Evidence supports the idea that markets fail to properly price information about companies that experience seasonal patterns in their earnings. The authors show that the abnormal returns exhibited by the stock prices of such companies are caused by market participants affected by behavioral biases.
The idea that a company’s business is seasonal is nothing new. What is new is trying to understand why the market is not properly pricing for this seasonality. The research suggests that investors and analysts overweight the more recent lower-earnings quarter, leading to a more pessimistic forecast, and subsequently underweight the positive seasonality quarter. For those companies that exhibit seasonality in their earnings, the median analyst correctly forecasts 93% of this seasonal shift in earnings, missing only 7%. Although this finding shows that analysts are taking the seasonal nature of the earnings into account, they are not fully adjusting their forecasts and properly accounting for earnings seasonality.
The recency effect is the tendency of people to be most influenced by what they have last heard or seen. Not surprisingly, investors suffering from the recency effect will be more likely to overweight recent lower earnings compared with the higher seasonality earnings from the year-ago period. Related to the recency effect—and perhaps an additional factor contributing to the mispricing—is the availability heuristic, which operates on the notion that something that can be recalled must be important.
Consistent with the predictions of the recency effect and the availability heuristic, when recent earnings are lower, the seasonality effect is larger. The authors find monthly excess returns of 65 bps in an equal-weighted portfolio and 76 bps in a value-weighted portfolio, both significant at the 1% level.
Read the entire article here. - Paul R. Rossi, CFA
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